New Directions for IPE: Drawing from

Behavioral Economics

Deborah Elms

IPES Conference

November 2006

Equity Premium Puzzle

Why do people simultaneously hold stocks and bonds? Puzzle: given low yield on bonds and standard

risk calculations, no one should hold both Unable to explain 6% difference in return

Puzzle holds from 1802-1990 Even concerns over stock market crash

insufficient to account for pattern

Solution: Myopic Loss Aversion

Two key elements for Thaler et. al. Mental accounting Loss aversion

Under mental accounting Evaluate stocks and bonds separately Viewed at various time intervals (esp. one year)

Loss aversion Short-term losses in stocks felt keenly Reinforced the more often reevaluation takes

place

Reevaluate Ken Scheve’s IO Article

Do macroeconomic priorities of citizens differ across countries? Answer—yes, especially with focus on inflation

and unemployment National-level variables account for most of

difference Inflation aversion and “acceptable”

unemployment levels not stable across countries

No convergence on “ideal” policy

But Add in Myopic Loss Aversion

Should prefer greater unemployment and less inflation under high inflation

If myopic loss aversion happening, key issue is not “what is current level of inflation?” but “is level of inflation rapidly rising or falling?”

If inflation is high but unchanged, less public demand for broad policy changes

The more often public gets information about levels, more volatile reactions become Election season critical

Historical Experience Matters

History important in setting baseline expectations of public over inflation/unemployment

More information leads to more reevaluation of status quo and changes from status quo Under loss, accept more risk

Optimal policy response impossible to achieve across multiple states

Design of monetary institutions will vary across states

Review of Paper

Why has IPE not incorporated insights of behavioral economics? Normative role of baseline expectations,

methodological concerns, and lack of knowledge Role of losses

Why do regulators opt for harmonization? Twin shocks drive perception of losses

Fairness What drives state behavior in GATT/WTO

negotiations? Law, power and fairness considerations